Q&A: Personal loan debt vs credit card debt

Dear Liz: I need to understand how credit reporting agencies treat personal unsecured loan debt versus credit card debt.

I am considering getting a personal loan from a reputable lender to pay down my credit card debt. The amount of my overall debt will still be the same, just in a different category. How will my credit score be affected?

Answer: What you need to understand is how credit scoring formulas treat installment debt (loans) versus revolving debt (credit cards). Credit reporting agencies maintain the credit reports used to create scores — but don’t bless (or curse) particular types of debt.

The personal loan’s overall effect on your credit scores is likely to be positive if you pay the loan on time. What you owe on an installment loan is typically treated more favorably than a similar balance on a credit card.

Installment loans have other advantages: You typically get a fixed rate, rather than the variable one charged on most credit cards, and your balance will be paid off over the term of the loan, which is usually three years. If you stop carrying balances on your credit cards, you should be in much better shape: free of debt with potentially higher scores.

Often the best place to get installment loans is from credit unions, which are member-owned financial institutions that may offer lower interest rates.

Avoid any lender that gives you a high-pressure sales pitch, that offers you a loan if you have bad credit or that pitches debt settlement, which is far more dangerous to your finances than a personal loan.

If the lender tries to tell you about a new “government program” that wipes out credit card debt or tries to collect big upfront fees, you’ve stumbled onto a scam.

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Q&A: Can installment loans help repair bad credit?

Dear Liz: I am working on paying my bad debt from the past to rebuild my scores. I have one credit card that I pay in full every month, but no installment loan. I recently was given the opportunity to take a car loan with monthly payments I could easily afford. Here is my confusion: Taking on more debt while trying to eliminate past debt is usually not advisable. But I also know creditors like to see both revolving and installment credit. Am I OK taking the car loan to give the “well-rounded use” credit, or should I just put that extra money to pay off my past debt?

Answer: Paying off old bad debts typically doesn’t help your credit scores. If these accounts are now in collections, the damage has been done and won’t be erased by your payments.

And if the accounts are in collections, the money you’re paying probably isn’t going to the creditors you originally owed. Those creditors probably sold your debts to collection agencies for pennies on the dollar. If that’s the case, those collectors may be willing to settle for 50% or less of what you owed the original creditor. If you have the cash to make lump sum offers and you decide to take this route, get written assurance from the collector — in advance and in writing — that any remaining debt won’t be resold to another collector. Also, reserve some cash for the tax bill, because forgiven debt is usually considered taxable income.

You also can request a “pay for deletion,” which means the collection agency stops reporting the collection account to the credit bureaus in exchange for your lump sum payment. Getting rid of the collection could help your scores, but many collectors resist this step.

Now, back to your question. Adding an installment loan such as an auto loan, mortgage or student loan to your credit mix can indeed help rehabilitate troubled scores. The scoring formulas like to see people responsibly handling a mix of credit accounts.

If you decide to take out a car loan, shop around for a lender before you commit. Those affordable payments you were shown could disguise a bad loan — one with a sky-high interest rate, a long repayment period or both. It’s wise to make at least a 20% down payment on any car purchase and to limit the loan term to four years or less.

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